When you dig into how REITs operate, they become fairly complex investments. Most of this isn’t as important for investors but is important for REIT operators. We will look at two specific restrictions or rules that REITs must follow.
REIT Operating Basic
REITs operate under certain restrictions, which afford REITs specific tax benefits. One of those restrictions is that REITs must distribute (i.e., dividends) 90% of their taxable income to investors. If there are no earnings to distribute, the distribution is considered a return of capital and not taxed. Paying 90% of income disqualifies the REIT from paying corporate taxes.
For investors, there may also be tax advantages from REIT dividends. Dividends typically come in two categories —regular and qualified dividends. Regular dividends are taxed at the investor’s ordinary income tax rate. Qualified dividends are generally taxed at the capital gains rate.
Return of capital might be thought of as a dividend, but as mentioned above, it is the return of principal and not taxed.
The next two sections get into the main topics of this article, which highlight two more REIT restrictions.
10% Rule
The 10% rule is related to safe harbor rules. When a REIT sells property as “inventory,” it can avoid being categorized as a prohibited transaction by meeting several requirements. One of those requirements is the 10% rule1.
This rule is based on the fair market value (FMV) of all REIT properties at the beginning of the year. At the beginning of the year, properties sold as inventory cannot exceed 10% of the FMV of the REIT’s assets.
30% Rule
This rule was introduced with the Tax Cut and Jobs Act (TCJA) and is part of Section 163(j) of the IRS Code. It states that a REIT may not deduct business interest expenses that exceed 30% of adjusted taxable income.
REITs use debt financing, where the business interest expense comes in. Under the TCJA, the business interest expense deduction is a mechanical computation.
Note that the 30% rule seems to be more dynamic than static. In 2019 and 2020, the limit was raised from 30% to 50% by the Coronavirus Aid, Relief, and Economic Security (CARES) Act. In 2021, the business interest expense calculation made the deduction more restrictive2.
The above two rules pertain mainly to REIT operators rather than investors. Investors will mostly be concerned about researching a REIT as a viable investment and the taxation of their distributions.
1 https://www.mcguirewoods.com/client-resources/Alerts/2015/12/Congress-Passes-Tax-Laws-Affecting-REITs
2 https://www.thetaxadviser.com/issues/2022/dec/sec-163j-business-interest-limitation-new-rules-2022.html
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.
REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.
There are risks associated with these types of investments and include but are not limited to the following:
- Typically, no secondary market exists for the security listed above.
- Potential difficulty discerning between routine interest payments and principal repayment.
- Redemption price of a REIT may be worth more or less than the original price paid.
- Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.
- There is no guarantee you will receive any income.
- Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.
This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
FAQs
30% Rule. This rule was introduced with the Tax Cut and Jobs Act (TCJA) and is part of Section 163(j) of the IRS Code. It states that a REIT may not deduct business interest expenses that exceed 30% of adjusted taxable income. REITs use debt financing, where the business interest expense comes in.
What is the 10 percent rule for REIT? ›
10 percent of the outstanding vote or value of the securities of any one issuer may be held (again, a taxable REIT subsidiary is an exception to this requirement) 25 percent of the total assets can be securities.
What is the 75 75 90 rule for REITs? ›
Invest at least 75% of its total assets in real estate. Derive at least 75% of its gross income from rents from real property, interest on mortgages financing real property or from sales of real estate. Pay at least 90% of its taxable income in the form of shareholder dividends each year.
What percentage of my portfolio should be in REITs? ›
“I recommend REITs within a managed portfolio,” Devine said, noting that most investors should limit their REIT exposure to between 2 percent and 5 percent of their overall portfolio. Here again, a financial professional can help you determine what percentage of your portfolio you should allocate toward REITs, if any.
What is the REIT 10 year rule? ›
The final regulations include a 10-year transition rule for existing structures. The transition rule treats domestic corporations that own REIT shares as domestic even if they would be look-through persons under the final regulations.
What is the 30 3 30 rule? ›
It's pretty simple. You get 30 seconds to hook us with your pitch (either deck or in person). If we like that, we'll take three minutes to further understand the opportunity. Based on that, you might score a 30 minute face-to-face meeting.
What is considered bad income for a REIT? ›
For purposes of the REIT income tests, a non-qualified hedge will produce income that is included in the denominator, but not the numerator. This is generally referred to as “bad” REIT income because it reduces the fraction and makes it more difficult to meet the tests.
What is a good ratio for a REIT? ›
Even with a challenging market, REITs are considered a staple for many investment portfolios thanks to the 90% rule. As the name implies, this rule stipulates that real estate trusts must distribute 90% of their taxable earnings to existing shareholders.
What is the 90% rule for REITs? ›
To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.
How much debt should a REIT have? ›
Think about when you buy a house, you generally have 80% of the houses in the form of debt, only 20% in the form of your equity, not quite the same thing, but generally, if a REITs operating in a 50% equity, 50% debt capitalization, that's perfectly reasonable.
Since they operate as a pass-through tax entity, investors may enjoy higher returns and a more beneficial tax situation. There are still taxes to consider, however. These may be considered ordinary income, qualified dividends or capital gains, depending on how and when it's received.
How long should you hold a REIT? ›
Is Five Years the Standard "Hold" Time for a Real Estate Investment? Real estate investment trusts (REITS) and other commercial property investment companies frequently target properties with a five-year outlook potential.
Do REITs do well in a recession? ›
REITs allow investors to pool their money and purchase real estate properties. By law, a REIT must pay at least 90% of its income to its shareholders, providing investors with a passive income option that can be helpful during recessions.
What is a good amount to invest in REIT? ›
The Cheapest Option: REITs—$1,000 to $25,000 or more
These are securities and are traded on major exchanges like stocks. They invest in real estate directly, either through property purchases or through mortgage investments.
What is the payout rule for REIT? ›
To qualify as securities, REITs must payout at least 90% of their net earnings to shareholders as dividends. For that, REITs receive special tax treatment; unlike a typical corporation, they pay no corporate taxes on the earnings they payout.
What is a good amount to invest on a REIT? ›
The Cheapest Option: REITs—$1,000 to $25,000 or more
These are securities and are traded on major exchanges like stocks. They invest in real estate directly, either through property purchases or through mortgage investments.
